Last year Gator Getters, Inc. had $50 million in total assets. Managem

QUESTION

Last year Gator Getters, Inc. had $50 million in total assets. Management desires to increase its plant and equipment during the coming year by $12 million. The company plans to finance 40% of the expansion with debt and the remaining 60% with equity capital. Bond financing will be at a 9% rate and will be sold at its par value. Common stock is currently selling for $50 per share and flotation costs for new common stock will amount to $5 per share. The expected dividend next year for Gator is $2.50. Furthermore, dividends are expected to grow at a 6% rate far into the future. The marginal corporate tax rate is 34%. Internal funding is available from additions to retained earnings is $4, 000,000. A. What amount of new common stock must be sold if the existing capital structure is to be maintained?Hint: Information you need:You need existing structure, tax rate, internal funding through retained earningsExisting capital structure: $50 million in total assetsB. Calculate the weighted marginal cost of capital at an investment level of $12 million.Hint: Information you need:Bond financing rate, tax rate, expected dividend, currently selling common stock price, flotation costs and expected dividend growth rate
Concept: Value of stock can be calculated by discounting future dividend payments. It can be evaluated by Gordon Growth Model. According to Gordon Growth Model: Value of stock = Next Dividend/(k-g) Where g -> Dividend Growth Rate k -> Required Rate of Return/Cost of Equity Weighted average cost of capital can be calculated as: WACC = Weighted Cost of Equity + Weighted Cost of Debt (after tax) = Weight of Equity*Cost of Equity + Weight of debt *Cost of debt (after tax) Pre-tax cost of debt will be the effective annual rate on the bond. After-tax cost of debt = Pre-tax cost of debt*(1-Tax) Required amount of new common stock can be calculated as: Amount of new common stock (to Sell) = Equity Needed Addition to Retained Earnings Solution: For Gator Getters, Inc.: (a) Capital structure for expansion: Debt = 40% Equity Capital = 60% Require increase in plant & equipments = $12 million Equity needed = $12 million*60% = $7.2 million Addition to retained earnings = $4000000 = $4¦

ion So, New common stock require to sell = $7.2 million “ $4 million = $3.2 million Therefore, new common stocks of $3.2 million are required to sell. (b) Next year dividend = $2.50 per share Current selling price = $50 per share Floating cost = $5 per share So, Actual market price = $50 “ $5 = $45 per share Dividend growth rate = 6% According to Gordon Growth Model: $45 = $2.50/(k-6%) Required rate of return (common equity) = 11.56% Pre-tax cost of debt = 9% Tax rate = 34% After-tax cost of debt = 9%*(1-34%) = 5.94% According to WACC formula: Weighted marginal cost of capital = 40%*5.94% + 60%*11.56% = 9.31% Therefore, weighted marginal cost of capital is 9.31% .

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